Tuesday, June 28, 2011

How Do Companies Set A Price For Their Products?

On vacation a few years back, I traveled with a group of friends and family to a foreign country.

While my family and I seemed somewhat local, the people we traveled with were clearly tourists. One day, all of us went out to dinner, and each of us were handed menus. Later, when I caught a glimpse of our friends’ menu who were sitting at another table, I was shocked to see that we were being charged two different prices for the same foods. The manager intentionally charged for the food according to how much he believed would make him the most money. Analyzing the situation now
with a much different perspective than I had viewed it with many years ago, I realize the restaurant manager must have found an effective price-point for the classifications he grouped us in. Clearly, he acknowledged charging everybody lots of money simply did not work, and, though unethical, his actions made me wonder about the practice.

This brought me to an interesting question: how do companies set the price of an item? In order to maximize profits, they must find an exact price at which the worth of the product or service becomes valuable enough for a consumer to buy. So what determines the price at which profits are highest, especially considering each individual has their own opinion as to the “ideal price”?

As any economics course would teach on day one, the intersection between the supply and demand curve determines equilibrium quantity and price, but what are some of the tools a company can use to determine where this intersection may be?

The answer obviously is different for different industries. In the case of Boeing, factors like fuel prices and growth of emerging markets and currency exchange rates factor heavily in pricing their products (planes and plane parts). However, in the case of the local pizza shop the pricing may be much less scientific but just as relevant to the long term success of the business.

Some of the tools that industries use to price their products are:
- Market Research / surveys (opinion)
- Market Research - Conjoint Analysis (examines the direct trade-ofs
among competing products)
- Market Research - perceptual mapping - assesses the benefits of
various products that may not be direct substitutes for one another,
and seeks to identify the benefit of one product that no other product
- Competitive Analysis (what is the other guy doing, price-wise ?)
- Historical Trend analysis (where is the price of this product most
likely to go)
- Purely quantitative materials costing (what does it cost me, and
what kind of premium should I be getting? AKA Floor pricing)
- Use a Life Cycle Strategy - Price a product for early adopters to
take advantage of its extra value early, then plan to reduce the price
later on for increased market share.

The science behind some of these techniques is astoundingly sophisticated, and I know for a fact that some industries spend millions on pricing their inventory, including Television Companies (price of Advertising), Pharmaceutical Companies (price of medications in line with Insurance Company expectations), and even Chocolate Manufacturers

Other factors also affect the ultimate price of a product:
- Speculation (Oil prices are affected by the perceived lack of
inventory in the future)
- Coolness Factor (Apple products are sold at a solid premium because
they are cool)
- Political Climate (fluctuations in the currency of a country that
produces a certain product will affect the price)
- Fluctuating Weather (especially for produce, etc)
- Artificial control of world supply (diamonds)

©2011. All rights reserved.

No comments:

Post a Comment